Mr. Lindsey Goes To Washington

Once an economics professor at Harvard and an ardent Keynesian, Lawrence Lindsey, a governor at the Federal Reserve, is fanning the flames of the Reagan revolution and sounding the death knell for an economic orthodoxy in decline.

Ronald Reagan’s decision to pull an untested idea into the 1980 presidential campaign-supply-side economics-posed the gravest threat to an economic paradigm since John Maynard Keynes shattered classical theory in the 1930s. Supply-siders, focusing on the supply-side, or incentive effects of tax policy, gained the upper hand during the Reagan years. They maintained that revenue losses from tax cuts would at least be partly offset by increased investment and productivity. But since the president left office in 1989, the lips of his successor have parted, and state and federal taxes have crept steadily upward-virtually canceling reductions of the prior decade. As a result, many supply-siders lately have lamented disarray among conservatives and groused about the need for a new champion.

Enter Lawrence B. Lindsey, 37, a Harvard-trained economist and one-time devout Keynesian, confirmed last November as governor of the Federal Reserve’s Richmond district. Lindsey, a member of the Council of Economic Advisers during the Reagan administration, says he originally thought the supply-side theory to be hokum and that explosive growth of the 1980s was the product of Keynesian demand stimulus. Further, he thought the reduction of the money supply engineered by Paul Volcker, Fed Chairman before the Reagan presidency, to be the pivotal factor in hacking down inflation. But after studying data in the wake of the Economic Recovery Tax Act of 1981, Lindsey discovered otherwise. In a 1990 book, “The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy,” he makes a compelling case: While the Reagan tax reductions did drain revenues, they offset this loss by pumping up economic output between 2 and 3 percent.

Lindsey’s bold pronouncements on taxation and growth stand in marked contrast to the more timid proposals of the Bush administration and an often painfully gradual approach to monetary stimulus taken by his boss, Fed Chairman Alan Greenspan. In his book, Lindsey called for:

Eliminating all federal taxes for single people earning less than $6,000 and couples earning less than $ 12,000.

Restoring IRA deductions with a ceiling of $5, 000 per year.

Levying a single, marginal tax rate of 19 percent on all taxable income, including capital gains.

Taxing all compensation above $ 12,000, including health insurance and other fringe benefits.

Lindsey says the changes, though revenue neutral, would stimulate economic activity among all classes of taxpayers.

How did a supply-sider end up working first as an economic adviser to President Bush, and now as a Fed governor? The road to the Fed’s marble palace on Constitution Ave. was littered with obstacles.

Analysts interpreted the president’s nomination of Lindsey in January 1991 as a signal that he was prepared to embrace a more conservative, pro growthagenda. But the Senate delayed Lindsey’s confirmation until late November-stringing out the hearings even longer than those for controversial Clarence Thomas, who was ultimately confirmed as a Supreme Court Justice. Senators from the Fed’s Richmond district, comprising Maryland, Virginia, North Carolina and South Carolina, argued that Lindsey had no direct knowledge of the region’s agricultural and industrial interests. (He has lived in Virginia for three years, fulfilling statutory residency requirements for a Fed governorship.) But observers on the Right viewed the stall tactics as a partisan attack on supply-side economics. Indeed, some senators, including Michigan Democrat Donald W. Riegle, used the hearings to vent their anger over a laundry list of items, ranging from the Fed’s unwillingness to ease interest rates more quickly to the mounting budget deficit. Riegle ascribed the latter partly to the Reagan tax cuts.

While Lindsey defends the platform put forth in “The Growth Experiment,” he takes special pains to emphasize the common ground between himself Greenspan and the president-including their mutual desire to cut the capital gains tax. Lindsey, whose term as Fed governor expires in January 2000, opposes most forms of fiscal stimulus, including those provisions riding piggyback in the Bush tax package.

In a wide-ranging conversation, Lindsey handicaps the Democratic presidential candidates, analyzes the prospects for economic recovery and elaborates on his blueprint for growth. CE senior editor Joseph L. McCarthy caught up with the shirt-sleeved governor in his opulent Washington office, replete with a 12-foothigh cathedral ceiling and a working stone fireplace.

SQUEEZING THROUGH THE BOTTLENECKS

What’s the cause of the current recession?

Economics models suggest that any downturn in the business cycle is caused by a bottleneck in the economy. The current recession was caused by a whole bunch of bottlenecks arriving all at once.

Worldwide, we completely changed the way we regulate our banking system. We moved to stricter, capital-based requirements from reserve-based requirements.

There was also the Fed’s decision to decelerate the rate of money growth to achieve price stability. People take out debt and arrange their positions based on certain expectations. Throughout the 1980s, we consistently had annual money growth of between 8 and 9 percent. We’ve now cut that to around 4.5 percent. People are either disappointed or they’re surprised. But they’re also less inclined to go into debt. That means funds are going to pay off debt instead of to buy goods, and that’s a demand-side bottleneck for the economy.

Given these bottlenecks, I think the real story is not why we had a recession, but that the recession was relatively mild.

Do you think that interest rates are low enough to quickly ensure a recovery?

I think the recent series of rate cuts has ensured that there is substantial monetary stimulus in the pipeline. But we’re monitoring things closely.

SUPPLY-SIDE VICTORY

Do you favor a tax cut?

I think a capital gains rate reduction would be particularly beneficial. Another economic bottleneck is that we have had a record high average capital gains tax rate. That tends to put friction on the capital markets. But I don’t think it’s necessary to have a major fiscal stimulus. I’ve gone on record as advocating a revenue-neutral tax change, tinkering here and there to make the system more efficient.

Overall, federal and state taxes seem to be creeping higher. Do you think that legislators have lost sight of some of the lessons learned in the Reagan era?

I think the picture is mixed. No one wants to go back to the pre-Reagan days of 70 percent taxes. I’ve read that the head of an ultraliberal, labor union-sponsored think tank here in Washington said that his idea of the top marginal rate was 40 percent. Well, to some extent, maybe what supplysiders should do is declare victory. If the field of debate is now whether the top rate should be 28 percent or 40 percent, Reagan has won the argument, and we’re quibbling over the details.

It is true that we’re seeing an upward trend in taxes and tax rates. On net, that’s harmful to the economy. But I think it’s the loss of a skirmish in a war that you’ve essentially won.

You’ve been quoted as saying that the next battle is going to be on the spending side, not the tax side. Can you elaborate?

We have to hold government accountable for providing a quality product, comparable to the money we pay in taxes. Take a look at the public school system. Some folks say the problem is a lack of funding. That’s nonsense. During the 1980s, after adjusting for inflation, per pupil spending on education went up 25 percent. That’s a whopping increase. And you don’t see an improvement in quality.

The problem is that we have a highly unionized public-sector monopoly providing a shoddy product. The contrast with our higher education system is frightening. Higher education is a major export product in America. In that area, we have a system that’s competitive, non-monopolistic, generally non-unionized-and vastly more efficient.

COP ON THE BEAT

During the primaries, Republican presidential candidate Patrick Buchanan has hammered away at the fact that President Bush committed supply-side heresy-that is to say, he has raised taxes. Do you agree?

President Bush did raise taxes, but let’s look at the reason why.

During his term, the president has faced a Congress in which both houses were overwhelmingly controlled by the other party. We often forget that during the first six years of the Reagan administration, the Senate was in Republican hands.

Looking back at the 1990 budget agreement, Senate Majority Leader George Mitchell and House Speaker Thomas Foley told the president that he wouldn’t get any legislation passed unless he agreed to a tax increase. They held him hostage.

One debate raging in the presidential campaign involves protectionism. What do you think of Pat Buchanan’s “America first” platform?

Fundamentally, I disagree with Buchanan. I’m an unabashed internationalist. I think free trade is good for America. A rapidly growing world economy is not only in our interest from a humanitarian point of view, it’s in our interest from a very narrow, selfish, economic point of view.

We’re the suppliers of both the capital goods and technology that permit the world to develop. To keep developing, you need two things. First, you need an economic environment on a global scale that allows the capitalist economy room to breathe. You need bordering markets, relatively stable prices, and rules of the game. So I think we have to be active economically in GATT and with the IMF.

What the world also needs-and we tend to forget this-is a cop. The market miracle does not work if there are not policemen on the street. Like every other American, I don’t like paying the taxes to be the world’s policeman. But we’re the only ones who can do this, because we are the world’s only superpower. To have us withdraw from the world-to say we’re tired of being the cop on the beat-is an invitation to disaster.

MARKET METAMORPHOSIS

Looking at the field of Democratic presidential contenders, what do you make of Governors Clinton and Brown firing the “fairness” cannon at Republicans and pressing for tax relief for the middle class?

The interesting thing about the fairness issue is that there are many ways of presenting the data to prove whatever point you want.

The evidence is fairly conclusive that the tax changes made during the 1980s were probably distributionally neutral, or actually somewhat progressive (see sidebar on page 25). Higher-income people are actually paying a much higher share of the income tax than they were in 1980. Middle-class taxpayers were the big losers from the unindexed taxes of the late 1970s. Because of inflation, they continually faced an automatic tax increase.

One thing that complicates perceptions of the tax picture is changes in the Social Security tax. The funny thing about that tax-unlike all others-is that your benefits are linked directly to the taxes that you pay. Looked at that way, the social security tax-transfer system is extremely progressive.

Here’s an example: Someone who makes $15,000 a year gets back in credit-value terms about $1.40 for every $1 they pay in taxes. An upper-income worker, meanwhile, gets back only 70 cents on the dollar. Some who complain about inequality and fairness look at the social security tax side, but not the transfer side. That’s telling only half of the story.

But there’s a more fundamental reason behind the demands for middle-class tax relief. Another trend we’ve seen is a change in the economic returns-salaries-to workers with certain types of skills. Starting in the 1970s-and this has nothing to do with taxes, supply-side economics or Reagan-the returns to workers in so-called knowledge-based industries (information technology and other high-tech sectors) increased dramatically. At the same time, the returns to laborers whose occupations are based on physical strength have decreased.

As these returns have changed, we’ve seen changes in income distribution. In the short term, that has led to an increase of income at the top. But from a supply-side point of view, you want to go where your supply is underutilized. We’ve an increasing number of people who don’t have skills that provide top returns. Our challenge is to find a way to integrate them into the system and make the most of their talents.

In that regard, I don’t think a simplistic redistribution of income through tax policy is going to do anything. The problem is more fundamental than that.

So what do you think about the tax plans proposed by the Democrats?

In terms of the proposal by the House of Representatives, there’s simply no net fiscal stimulus there. Plainly, it is a redistribution proposal that would not be helpful to economic growth.

Does the Bush tax plan move things further in the direction you would like to see?

The president’s proposal included some solid long-term structural changes, including a provision for a lower capital-gains tax. But it was also designed to provide a short-term fiscal stimulus through a homeownership tax credit and a short-term investment tax credit. I’m less convinced of the need for those types of stimulus.

VAT is best modeled as a labor income tax plus a one-time capital levy. The tax is said to be pro-savings because it’s a single, one-time tax on wealth.

I’m somewhat skeptical, though, because once you get a VAT in place, it’s a very easy tax to raise.

RADICAL PROPOSALS

In your book, “The Growth Experiment,” you proposed some radical tax changes. Why do you think businesses should be taxed on cash flow rather than on income?

The big change in the cash flow approach is that business equipment would be an expense and the current bias toward debt finance would be eliminated.

You also said individuals should be taxed on the whole of their income, including reimbursements from health insurance. Why?

I think we’ve been inviting the use of fringe benefits as a form of compensation. And that’s exploded as tax rates have gone up throughout the decade. That’s not what you have in mind when you design a progressive tax system. The current system encourages the consumption of goods that are tax favored. Health insurance is one of them.

If you could make a single change to the tax system, what would it be?

Bring down the rates and broaden the base. I know that’s two changes, but they’re part of the same thing. We don’t need an across-the-board tax change. Ideally, any changes we make should be revenue neutral. But rates have been creeping upward in recent years. We could quite easily get back down to a 21 percent marginal tax rate by moving to bring in the fringes.

Did The Rich Get Richer Under Reagan?

Politicians opposed to supply-side economics have disparaged the Economic Recoveg Tax Act of 1981, introduced by then-President Ronald Reagan, as a “tax cut for the rich.” In an excerpt from his 1990 book, “The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy,’ Lawrence B. Lindsey debunks the arguments of ERTA’s critics.

We often hear that “under Ronald Reagan the rich got richer and the poor got poorer,” and that the 1981 tax cuts were a big windfall for the rich and only for the rich. It would seem to be common knowledge. But what everyone knows isn’t always true, and in this bit of common knowledge there is no more than a tiny kernel of truth.

During the early part of Reagan’s first term, the rich did get richer while most of the rest of the country stayed even. Some lost ground. The causes were not the tax cuts but record high interest rates and the back-to-back recessions of 1980-82. When interest rates go up, lenders get richer and borrowers get poorer. Since the lenders tend to have more money than the borrowers in the first place, high interest rates do make the rich richer. Recessions reinforce this process because recessions are costliest to middle-and working-class people who lose their jobs, while the rich rarely become unemployed.

Common knowledge stumbles at this point because rising interest rates and higher unemployment began well before Reagan became president. For example, a common bit of evidence used by Reagan critics is, that the poverty rate rose after the tax cuts. Actually, the poverty rate bottomed out at 11.4 percent in 1978. It hit 13 percent in 1980 and 14 percent in 1981, the year Reagan took office but before his economic program was in place. The poverty rate peaked at 15.2 percent in 1983, by which time the tax cut was still only three-quarters in place. In short, two-thirds of the rise in the poverty rate occurred before Reagan’s tax and budget policies could take hold, and all the rise occurred before ERTA [the Economic Recovery Tax Act of 1981] was fully in place. By 1985 the poverty rate was back down to the level it was at when Reagan took office. It dropped even further during his last three years in office. Thus, though the poverty rate rose in three of [Jimmy] Carter’s four years as president, it fell in six of Reagan’s eight years.

Consider the “rich got richer” critique. When interest income rises as a share of national income the rich get richer. This is because the rich derive more of their income from investments than most people. Interest income did increase its share of national income during Reagan’s first term. Again, however, the trend had started under Carter. In 1976, the year before Jimmy Carter took office, interest income was 9.2 percent of personal income. By 1981, when Ronald Reagan entered the White House, it was up to 13.3percent. The interest share of personal income peaked in 1985 at 14.4 percent of income. Thus three-quarters of this windfall to the rich occurred before Reagan took office. Like the poverty rate, interest income as a share of personal income fell in the latter half of the Reagan presidency.

Who got richer under Reagan? Taking into consideration data from both Reagan terms, the answer is that, on average everyone did. The real income of the median family rose over $3,000 under Reagan, after falling that same amount between 1973 and 1981 (the largest such retreat since the Great Depression). Continuing the trend of the late 1970s, families above the median did best early in the administration, with everyone else catching up later as the economic recovery continued apace. This situation had more to do with macroeconomic trends than with the direct effect of the tax cuts however.

The phrase “tax cuts for the rich” has become a staple of the rhetoric of anti-Reagan politicians. Even the most cursory look at the evidence, however, shows ERTA raised the share of the tax burden borne by the rich. The top 0.1 percent of all taxpayers (roughly speaking those making over $200,000 a year) saw their share of income tax payments rise from 7 percent in 1981 to 14 percent in 1986. The share of taxes borne by the top 2 percent of taxpayers (roughly those making over $60,000) rose from 26 percent in 1981 to 34 percent in 1986. Taxpayers on the bottom half of the income scale saw their share of tax payments fall from 7 percent at the start of the decade to only 6 percent by 1986. The great American middle class, people earning between $20,000 and $60,000 in the early 1980s saw their tax share fall from 67 percent to 60 percent between 1981 and 1986. They received the bulk of the Reagan tax cuts. If the rich ended up paying a bigger share of taxes, everyone else must have taken a bigger cut than the rich.